Transcript Lecture 25

Trade & Macro
Lecture 25
Dr. Jennifer P. Wissink
©2016 Jennifer P. Wissink, all rights reserved.
November 17, 2016
The Open Economy with Flexible
Exchange Rates

Recall: The exchange rate is the ratio at which two
currencies are traded, or the price of one currency in
terms of another.

Floating, or market-determined, exchange rates
are exchange rates determined by the unregulated
forces of supply and demand.
– Haven’t always been flexible in the U.S.
– Not all countries have flexible exchange rates now.
– See Case, Fair & Oster appendix for history.
The Market for Foreign Exchange
Consider only 2 countries: the U.S. and the U.K.
 Consider the market for pounds.
 What does a pound cost in dollars?

– Suppose 1 pound costs $1.89
 (What
does a dollar cost in pounds?)
– 1 dollar costs £0.53
 The demand for pounds is comprised of
holders of dollars wishing to acquire pounds.
 The supply of pounds is comprised of holders
of pounds seeking to acquire dollars.
The Demand
for Foreign Exchange:
E.g., British Pounds
THE DEMAND FOR POUNDS: derived from the need to obtain pounds
to buy UK goods and services
1.
2.
3.
4.
5.
6.
Firms, households, or governments that import British goods into the
United States or wish to buy British-made goods and services
U.S. citizens traveling in Great Britain
Holders of dollars who want to buy British stocks, bonds, or other
financial instruments
U.S. companies that want to invest in Great Britain – build factories
there
Speculators who anticipate a decline in the value of the dollar relative to
the pound
US wanting to send foreign aid to the UK
The Demand Curve for Pounds

The demand for
pounds is downward
sloping.

When the $price of
pounds falls, British
made goods and
services appear less
expensive to U.S.
buyers.

If British prices are
constant, U.S. buyers
will buy more British
goods and services,
and the quantity
demanded of pounds
will rise.
i>clicker question
If the exchange rate goes
from EROld to ERNew in this
diagram, the dollar has
EROld
O
A. appreciated relative to
the pound.
B. depreciated relative to
ERNew
N
the pound.
The Supply of Foreign Exchange:
E.g., British Pounds
THE SUPPLY OF POUNDS: derived from the need to obtain dollars to
buy US goods and services
1.
2.
3.
4.
5.
6.
Firms, households, or governments that import U.S. goods into Great
Britain or wish to buy U.S.-made goods and services
British citizens traveling in the United States
Holders of pounds who want to buy stocks, bonds, or other financial
instruments in the United States
British companies that want to invest in the United States
Speculators who anticipate a rise in the value of the dollar relative to
the pound
The UK sending foreign aid to the US
The Supply Curve for Pounds




The supply of
pounds is upward
sloping.
When the $price of
pounds rises, the
British can obtain
more dollars for
each pound.
This means that
U.S. made goods
and services appear
less expensive to
British buyers.
Thus, the quantity
of pounds supplied
is likely to rise with
the exchange rate.
The Equilibrium Exchange Rate

An excess supply of
pounds will cause
the $price of pounds
to fall, the dollar will
appreciate against
the pound, the
pound will
depreciate with
respect to the dollar.

An excess demand
for pounds will
cause the $price of
pounds to rise, the
dollar will
depreciate against
the pound, the
pound will
appreciate with
respect to the dollar.
Purchasing Power Parity - The Law of
One Price




If the costs of transportation are small, the price of the
same good in different countries should be roughly the
same.
If the law of one price held for all goods, and if each
country consumed the same market basket of goods, the
exchange rate between the two currencies would be
determined simply by the relative price levels in the two
countries.
The theory that exchange rates are set so that the price of
similar goods in different countries is the same is known
as the purchasing-power parity.
Do we always see that....?
ER Comparative Statics:
Tastes
i>clicker question
If people in the U.S.
suddenly want more
stuff from the U.K. then
A.
B.
C.
D.
E.
the dollar appreciates.
the dollar depreciates.
the pound appreciates.
the pound depreciates.
two answers above
are correct.
ER Comparative Statics:
 Relative Price Levels

A high rate of inflation in one country
relative to another puts pressure on
the exchange rate between the two
countries
– there is a general tendency for the
currency of relatively higher-inflation
country to depreciate.

E.g.: Suddenly more inflation in the
US relative to the UK…
increases the demand for pounds
and decreases the supply of pounds.
– The result is an appreciation of the
pound against the dollar.
– Or depreciation of the dollar against
the pound.
ER Comparative Statics:
 Relative Interest Rates


The level of a country’s
interest rates relative to
interest rates in another
country is another determinant
of the exchange rate.
For Example:
– If U.S. interest rates fall
relative to British interest
rates;
1) US citizens may be
relatively more attracted to
British bonds & securities and
2) Brits are no longer so fond
of US bonds & securities.
– So  we see an increase in
the demand for pounds and a
decrease in the supply of
pounds.
– The result is a depreciation of
the dollar against the pound.
– Or the dollar weakens against
the pound.
ER Comparative Statics:
 Relative Rates of Growth-Case A

Sn
Suppose the US and the UK start to
experience growth, and the US is
growing faster than the UK.
–
–
–
Dn
–
–
–
Expect that the US would import more
stuff from the UK  demand for pounds
increases.
Expect that the UK would import more
stuff from the US  supply of pounds
increases.
But if the US is growing faster than the
UK, then the demand increase for pounds
is larger than the supply increase of
pounds.
The result is a depreciation of the dollar
against the pound.
Or the dollar weakens!
But…. If this is the case, then why does
it seem that not so long ago many
argued that the Chinese yuan should be
getting stronger against the dollar when
it was the case that China was growing
faster than the US? According to this
analysis, shouldn’t the yuan get
weaker? Not stronger??
ER Comparative Statics:  Relative Rates of
Growth-Case B








In China, growth has been export led, so it’s qualitatively different from
the previous story.
Let’s look at this from China’s eyes and the market for dollars in China.
Both the US and China were growing – China faster than the US.
But China was growing via its export markets.
So… the increase in the supply of dollars to China by the US was larger
than the increase in the demand for dollars by China.
So… the yuan would strengthen against the dollar.
The prediction was that sooner or
later the US would not want to import
as much from China & China would
want to import more from the US.
The complaint often raised and
debated was that the Chinese
government kept the yuan artificially
weak to support their export markets.
yuan
price of
a dollar
SO
O
DO
Quantity
of $s
The Effects of Exchange Rate es on
the Economy, i.e., Y*

If the $ depreciates  the $ is cheaper (weaker)
– US goods look cheaper to foreigners  EX 
– Foreign goods look more expensive to US  IM 
– U.S. products are more competitive in world markets, and
foreign-made goods look expensive to U.S. citizens:
 get expansion in US economy and Y* 
 so depreciation of a currency can stimulate an economy.
 BUT: What’s good for one is not good for all.
 AND: Depreciation of $ tends to  price level.

Do the opposite story for yourself…
Exchange Rate es and the Price Level


SO... how does depreciation of a
country’s currency tend to
increase the price level?
Recall: when the dollar weakens
EX and IM  AD shifts
rightward.
– If the economy is on the upward
sloping part of SR-AS, the
increase in aggregate demand is
likely to result in higher prices in
the U.S.
– If the price level rises in US, then
wages have a tendency to
eventually rise  SR-AS shifts
left.
– Also: if import prices rise due to
the weaker dollar, costs may rise
for business firms,  SR-AS
shifts left.
Monetary Policy w/ Flexible ER
i>clicker question
Will having flexible exchange rates tend to make monetary policy
weaker or stronger?
A. Weaker
B. Stronger
Monetary Policy w/ Flexible ER

Recall: Expansionary Monetary Policy

So... with relatively lower interest rates in the US 
– an increase in the demand for pounds and
– a decrease in the supply of pounds 
– the dollar depreciates 
– EX  and IM   a boost in AEd  Y  a larger multiplier effect!

So... if the purpose of the Fed is to stimulate the economy, dollar
depreciation might be a good thing – it helps increase the efficacy of
the monetary injection.
Fiscal Policy w/ Flexible Exchange Rates

Consider an increase in G to increase Y*

So... with relatively higher interest rates in the US 
– an increase in the supply of pounds and
– a decrease in the demand for pounds 
– the dollar appreciates 
– EX  and IM   AEd falls  Y  a smaller multiplier effect.

So... if the purpose of the “fiscal guys” is to stimulate the economy,
dollar appreciation is a bad thing – it decreases the efficacy of the
fiscal injection.

Note: the Fed could help bolster the multiplier by doing what?